Merrill Says Passive Hedge Funds Are Coming

We say: They are already here. But Merrill’s explanation of why the passive hedge fund movement is overdue is telling and insightful.

Hedge funds… The very idea makes many of us shudder. Besides the prospect of the odd fund implosion (Amaranth, Long-Term Capital, countless smaller firms), there is that niggling little detail about fees: two percent a year and twenty percent of returns is considered normal. For those of us who believe in Bogle's Cost Matters Hypothesis - i.e., you get what you don't pay for - that is tantamount to insanity.

Investors, however, seduced by the siren song of high promised returns (not to mention the glorious cachet of it all), have been throwing money at the hedge fund sector nonetheless. Hedge funds will pull in $132 billion in new assets in 2006, according to Merrill Lynch, far outstripping their best year ever. There are now as many as 7,000 funds managing over $1 trillion in assets, and analysts predict continued growth as far as the eye can see (no one ever said that rich investors were smart investors).

Against this backdrop, Merrill Lynch published an interesting new report last week entitled "The Emergence of Passive Hedge Funds." In it, the bank predicted the rise of "passively managed hedge funds."

"The argument for passive management is based on the idea that as the level of competition among active fund managers grows, it becomes more difficult for the average active manager to outperform their benchmark after fees," the report says. "Hence investors who have little skill in selecting outperforming active managers are much better off with a strategy that mechanically replicates the benchmark at a much lower cost."

Well, I couldn't have said it better myself.

In an industry that relies on the most elusive and limited commodity in all of investing - managers who can actually generate alpha on a consistent basis - the rush of new assets is a nightmare. Returns fall as investments get too crowded: in fact, Merrill Lynch says that overcrowding has made convertible arbitrage, one of the industry's mainstays, essentially a loser's game.

Drawing an interesting analogy with the mutual fund industry, the bank notes that the number of mutual funds in America grew from 550 to nearly 6000 between 1980 and 1995, which was about when index fund assets really started to take off. Meanwhile, we saw a similar explosion in the number of hedge funds between 1990 and 2005, with the funds count growing from 500 to 6,500. Will a similar expansion of passive assets take place?

The Merrill Lynch paper argues that hedge fund returns can be replicated in three ways: through fund of funds, through balancing risk factors between different instruments (currencies, commodities, stocks, etc.) or through "mechanical replication," i.e. using a systematic, rules-based methodology instead of active management to deliver results.

"Passive strategies, some of which are increasingly the focus of academic research, aim to provide returns similar to hedge funds without the need for active management. Because of their lower cost, we believe these vehicles have the potential to outperform actively managed hedge fund investments on an after-fee basis," explained Benjamin Bowler, co-head of Global Equity-Linked Research at Merrill Lynch.

What Bowler misses, however, is that passively managed hedge fund-like strategies have been here for some time. The huge growth of funds tied to indexes like the CBOE S&P 500 Buy-Write Index show that investors are eager for risk-limiting indexed strategies that promise relatively steady returns with hedged downside protection.

Moreover, there are over twenty long/short mutual funds on the market, with countless others under development. In particular, fund companies are actively developing 130/30 long/short funds, which pair a 130 percent long exposure with a 30 percent short exposure in an effort to outperform the market.

Within the exchange-traded fund space, developers have long been moving towards more hedge-fund-like strategies. The PowerShares DB Currency Harvest 10 Portfolio (AMEX: DBV), for instance, pairs currency futures in an attempt to capitalize on interest rate arbitrage. If the fund charges 2 and 20, and not 70 basis points, it would be a heged fund.

The Merrill report is worth reading, if only for the schadenfreude of watching the hedge fund train wreck happen in front of your eyes (11.5 percent of hedge fund managers quit last year, presumably because they didn't make the grade). The passive hedge fund movement is already underway, but the sooner Merrill's vision of a passive explosion takes place, the better: two and twenty is an awful price to pay for sub-par performance.